Pay off student loan vs. retirement savings

[Gazpacho]

Gazpacho, congratulations on making very intelligent financial decisions so far. You sound like you have an excellent financial head on your shoulders, and I'm sure whatever you decide will be reasonable.

Thanks! I've been very fortunate to get this job, fingers crossed it'll last. I've spent the past few years listening to classmates who haven't found jobs, so I made sure to put the maximum contribution in a Roth as an emergency fund. I'm also fortunate that I don't have extra expenses. The classmates who can't find jobs and have kids to support are really sad cases. One of them had a special needs child, and it's heartbreaking.

In addition to the dollars and cents here, I'd consider the psychology of the situation, too. Are you OK with taking 10 years to pay off your student loans? If so, I'd save for retirement, a house, etc. and treat your student loans as a fixed monthly expense.

I don't know what feels psychologically comfortable. Obviously paying interest never feels psychologically comfortable. Nor does not having an emergency fund. Back in my head, there's a nagging sense that I may die before the student loans are paid off. Life is unpredictable, as is death. If my student loans aren't paid off, my survivors aren't held liable for them. Should that factor into my decision? What about the fact that I can extend the payment period past 10 years if I run into financial hardship?

Would you feel a lot better if you could pay off your loans in 7 years? 5 years? If so, use an amortization scale to calculate the payment you'd need to get that accomplished, and then put what's left over into retirement and/or a separate emergency fund from your Roth. (I agree with others that it would be wise to build up a true savings account with 8 months of expenses.)

What is an amortization scale?

Is it hard to withdraw money from a Roth? I was planning to use that as an emergency fund rather than having a separate emergency savings account.

If your employer doesn't match until you've been there for five years and you haven't yet been there five years (that's how I'm reading your post), forget the 401(k) until you hit the five-year mark. You have less control over the investments, and depending on your employer, the fees may be higher than in an account you can control. Roth IRA is the way to go, or if you're over the income limit, traditional IRA that you can then convert to Roth.

Yes, my employer doesn't match until you've been there five years. At that point, the match becomes retroactive. So if I put in $1500 now and leave before five years, it doesn't get matched. But when I hit my sixth year, the $1500 becomes retroactively matched. If I put in $800 now, in five years $800 gets matched, etc. So should I still put $1500 in now? I don't see myself lasting five years at this place, but lots of people have said that and ended up spending their whole working lives there.

I'm also allowed to put in more than $1500, up to $16,500 I think. Anything above $1500 doesn't get matched at any time.

So if I allocate money toward retirement, I then have to decide which retirement fund. What are the advantages/disadvantages of putting it in a regular IRA, Roth IRA, and 401(k)?

Finally, how will this affect my credit score and ability to get a loan, especially a mortgage? If I pay off the student loan, that raises my credit score, but I'll also have less to put toward a down payment, which means higher mortgage rates and more to borrow.

[AxelAnnie]

You are kidding, right? Pay back the loans. That money was given to you in trust and good faith. You used it for you education. Now fuflill your obligation and pay it.back.

[BittyBug]

Yes, my employer doesn't match until you've been there five years. At that point, the match becomes retroactive. So if I put in $1500 now and leave before five years, it doesn't get matched. But when I hit my sixth year, the $1500 becomes retroactively matched. If I put in $800 now, in five years $800 gets matched, etc. So should I still put $1500 in now? I don't see myself lasting five years at this place, but lots of people have said that and ended up spending their whole working lives there.

This would be a highly unusual plan provision. Are you sure the plan doesn't instead match as you go along but with the company match and any related investment gains / losses not vesting (becoming yours) until you've reached 5 years of service? So the company match money would be in your account all along, but if you left prior to 5 years you wouldn't be able to take it with you because it would not yet be yours?

And what is the match? Is it dollar for dollar, so you put in $1,500 and they put in another $1,500? Or is something less? Either way, it's free money so unless your plan has really lousy and high cost investment options, think about whether you'd be better off putting any retirement money into the 401(k) rather than an IRA because worst case you don't stick around for 5 years and you'd end up in the same place (no match), but if you manage to stay long enough to vest, you'd get that company match boost from the 401(k) plan that you wouldn't from an IRA.

As for Roth vs. pre-tax, it depends.

[milanessa]

You are kidding, right? Pay back the loans. That money was given to you in trust and good faith. You used it for you education. Now fuflill your obligation and pay it.back.

[Anita18]

I think that may have been in response to Gazpacho's last post asking whether the fact that student loans aren't held liable on next of kin if she dies before paying them all back should factor into her choice between loan-paying vs retirement funding. Some can interpret that statement as intending not to pay them back at all.

But the original post was asking whether it was better to pay off the student loans early vs putting more into a retirement fund.

IMO it depends on what's more comfortable for you. My sister paid off all her loans early because she hates having debt, while I'm fine with paying them off slowly at the standard rate. (We both had about the same amount, less than $10,000.) I did some rudimentary calculations and estimated I'd save about $300 in interest, which wasn't worth my nervousness of not having a bigger emergency fund.

To be fair, $10,000 is nowhere near $100,000, so you'd be saving a lot more in interest if you paid them off early. Then again, you could also find yourself in a tough spot if you lost your job and didn't have a big-enough fund to tap into. I'm neurotic about this though, I have separate accounts and treat my Roth IRA as something I DO NOT TOUCH EVER. Aside to put the max amount in every year. Heck, I even treat my mutual funds as something I don't take out of ever, and I have a savings account on top of THAT. So yeah, YMMV. I don't think most people are as neurotic about their financial cushion as I am.

[Louis]

Echoing what BittyBug said, find out more about your 401(k). Is it a five-year cliff vesting with 0% vesting on employer contributions until year five, when they become 100% vested? Or is it a plan where 20% gets vested each year for five years? Either way, it might be a good idea to take advantage of it, but the second option would be a no-brainer.

Life is certainly unpredictable, but I wouldn't let death factor into the equation here unless you have some kind of diagnosis that makes you think you may die within the time period of your student loans. Probability says you'll live long enough to pay them off, so go with that. Bankrate.com has amortization schedules where you can "solve" for what payment will help you get your loan paid off in X number of years.

Withdrawing from a Roth is a subpar option because you want to leave that money in there to grow tax-free for as long as you can, and you're limited by how much you can contribute to a Roth. So if you withdraw $1,000 from a Roth versus a savings account, you lose the compound tax-free growth for the next however many years. E.g., say you're 25 and plan to start withdrawing for retirement at age 70. Assuming 6% rate of return over time, the $1,000 you have in your Roth will compound to about $13k by age 70. The $1,000 in your taxable account will compound to only about $7k, assuming 33% federal, state, and local taxes. The tax advantage of a Roth is really wonderful, which is why you're so limited as to how much you can contribute. IMO, it's OK to use the Roth as a "life-and-death emergency" (e.g., you get cancer) fund, but not a regular emergency fund (e.g., your car breaks down). Have a separate savings account for that.

Re: your credit score, as long as you make payments on your student loans, I don't think it will matter either way. Sometimes paying off your student loan may actually lower your credit score, as you have one less type of debt. E.g., paying off the mortgage on my former house actually lowered my credit score. And re: mortgage, these days you pretty much need 20% down unless you qualify for a special program like FHA. If qualifying for a mortgage is your goal, the cash on hand for a down payment will probably trump whatever extra monthly payment you have on the student loans.

[Gazpacho]

You are kidding, right? Pay back the loans. That money was given to you in trust and good faith. You used it for you education. Now fuflill your obligation and pay it.back.

I think that may have been in response to Gazpacho's last post asking whether the fact that student loans aren't held liable on next of kin if she dies before paying them all back should factor into her choice between loan-paying vs retirement funding. Some can interpret that statement as intending not to pay them back at all.

Uh, no. I wouldn't commit suicide just to not pay back loans!

Federal student loans are discharged upon death. If you die before 10 years, your survivors are not held liable for any amount that remains. This possibility is built in to the rates of the loan.

This would be a highly unusual plan provision. Are you sure the plan doesn't instead match as you go along but with the company match and any related investment gains / losses not vesting (becoming yours) until you've reached 5 years of service? So the company match money would be in your account all along, but if you left prior to 5 years you wouldn't be able to take it with you because it would not yet be yours?

Hmm, I interpreted it as not matching until you hit your sixth year and then retroactively matching, but I'll ask again.

Assuming 6% rate of return over time, the $1,000 you have in your Roth will compound to about $13k by age 70. The $1,000 in your taxable account will compound to only about $7k, assuming 33% federal, state, and local taxes. The tax advantage of a Roth is really wonderful, which is why you're so limited as to how much you can contribute.

You said 6%--is that the average rate I can expect? If the student loans are 6.8% and the average rate of return is 6%, then it makes sense to pay off the student loans, right?

Should I try to max out the Roth contributions before contributing to a 401(k) and/or regular IRA?

Re: your credit score, as long as you make payments on your student loans, I don't think it will matter either way. Sometimes paying off your student loan may actually lower your credit score, as you have one less type of debt. E.g., paying off the mortgage on my former house actually lowered my credit score. And re: mortgage, these days you pretty much need 20% down unless you qualify for a special program like FHA. If qualifying for a mortgage is your goal, the cash on hand for a down payment will probably trump whatever extra monthly payment you have on the student loans.

I'm confused. So if I want a mortgage, is it better to have extra money for a down payment, or less debt showing on my credit report?

[PrincessLeppard]

If you can put 20% down, your interest rate on your mortgage will be lower. I was only able to put down 10%, but my interest rate is still significantly lower than my friends who put down 0-5%.

[Garden Kitty]

I'd put a little money into more immediate "emergency" savings, but maybe not a full 8 months (since the roth is there in a worst case scenario). I'd put enough into the IRA to get the match (and try to stay the time to get the match unless an aternative offer made up for it financially). Then I'd go for the IRA Roth. While a Roth can be an emergency fund, I'd really try to think of that money as "off limits".

As someone mentioned, the choices depend a lot on what makes you feel secure. If you don't have a defined benefit pension, starting early and letting the money build is the best way to build up your balance for retirement.

I'd worry about using all the extra money to pay down loans without having addressed emergency and other funds as well.

You're paying the loan back and living up to all your obligations under the loan. You have no obligation to pay it back early, although if that is what makes you feel most secure, then there is some advantage in doing that. But there is no one way to do this, and any of the uses you describe are good. Kudos to you for saving the extra.

[Twilight1]

I am just on the tale end of my student loan... down to my last $6000 from $30000 which is pretty good!!

I say if you are already making your payments, retirement savings is a good way to go esp. if you can go openended. That is to say, my husband contributes $100 a month to his RRSP but can also make random deposits into it as well. That way, you are saving, but if some expense comes up, you have your $20000 nest egg, but also have the means to deal with random things that pop up in life. The odd payment on your student loan is cool.

I am a huge believer in retirement savings. I put in $200 a month in mine through work, but they also match that. Once my student loan is done, that $350 is being put in an RRSP. I am already used to not using that money, but that means, each month I will be contributing $750 (give or take) a month to my retirement.

Which in the grand scheme of things means, I could retire earlier and go on trips everywhere.

[Erin]

I would echo the sentiment that there is no wrong answer. I do think it's a good idea to contribute to the retirement fund up to the point that the company will match, even with the long vesting period because you will be kicking yourself if you do stay for five years and it turns out you could have had all those company matches. After that, I personally would split my extra funds between retirement funds and early payments (after establishing a bit more of an emergency fund as others have suggested) - that way you're hedging your bets to some extent.

[Anita18]

If you can put 20% down, your interest rate on your mortgage will be lower. I was only able to put down 10%, but my interest rate is still significantly lower than my friends who put down 0-5%.

The mortgage talk makes me since even though I'm a diligent saver (and have enough money socked away to last me about 1.5 years with no income), I'd still have to have 5x as much to pay for a 20% down payment for a house here...and then I remember that I live in SoCal and it's not quite normal.

Or maybe I'm really a crummy saver since I still see people talk about having an 8-month emergency fund on top of their savings for a house, and I'm still quite a ways from doing that even for a reasonably-priced house in other parts of the country. I wouldn't dare clean out my savings just to have a house though, I'd probably rent for the rest of my life.

[PrincessLeppard]

Here in the middle of nowhere , my mortgage is lower than rent on a comparable apartment.

[Louis]

You said 6%--is that the average rate I can expect? If the student loans are 6.8% and the average rate of return is 6%, then it makes sense to pay off the student loans, right?

Personally, I don't believe you can expect any rate of return . But 6% is a pretty conservative estimate for a balanced portfolio of equities and bonds over time.

Keep in mind that your student loan rate is 6.8% minus whatever tax deduction you're able to take (if any), so the effective interest rate is lower.

Should I try to max out the Roth contributions before contributing to a 401(k) and/or regular IRA?

Contribute to the maximum match your employer gives. Then max out your Roth. Then if you have any left over, back to 401(k).

I'm confused. So if I want a mortgage, is it better to have extra money for a down payment, or less debt showing on my credit report?

Generally, I'd say more money for a down payment.

[OlieRow]

Oooh, I was wondering almost the same thing! I'm a recent grad with essentially twice the debt () but my employer doesn't match any retirement savings. Most of my loans are at 6.8% although I have a couple at 7.2% and one at something like 7.5%. My current plan is to use my 6 mo. grace period on the federal loans to build up an emergency fund and then consolidate them to do income based repayment for 3 years until I can make enough to really put a dent into the loans. The income based repayment plan makes it a 30 year loan and I definitely plan to pay them off sooner than that. There's a program where if you work for a non-profit and make 10 years of ontime payments the government forgives the balance, but I don't know that that's feasible for me or that the plan will even be around in 10 years given that the government would stand to lose tons of money if everyone tried to take advantage of it.

A smaller portion of my debt is state loans which don't have a grace period and I likely can't afford the full payment so I've put them in deferment with the plan to pay what I can towards them. If I stuck to my budget exactly (which I think I can do) and didn't have any major unexpected expenses come up then I could probably scrape by paying the state loan too, but by putting it into deferment it won't be an issue if I can't make the full payment one month. I'd be looking at a situation where 40% of my take home pay would be towards loans.

I know that starting to save when you're young is ideal since it maximizes your savings, but would I be doing myself a big disservice by building an emergency fund and then putting almost everything else I can scrape together towards my loans (extra going to the highest interest rate ones first)? With the debt being so high, that's a ton of interest paid if I drag out the repayment. My bind is really only temporary as I can expect my income to increase significantly (4x?) after 3 years but I still want to be financially smart now.

[AxelAnnie]

My apologies. . .I misunderstood your question (my bad. . Reading too quickly at the carwash). I really struggled to repay my loans. . . I was the first in my family to go to college. . . I felt so honorable that I paid them. So many people don't. So I humbly eat crow.
given the economy I am hesitant about investments?401K or anything else. We lost a bucket load in the last three years. Had it been under the mattress. . . where I like it. . .We'd still have it. Good luck.

[Twilight1]

It was ingrained in me very young to think about retirement savings because so many people will be accessing CPP, that their is fear we won't get it for when my generation retires. I don't know if that is true or not.

I was the first to complete school in my family of origin too. I am happy that I am down to my last year and a bit. (I think 16-17 months left). I utilized interest relief for as long as I could and I am kind of kicking myself for that as I would be in a much better position if I had started repaying my loans sooner. Aw well, live and learn...

[Gazpacho]

I felt so honorable that I paid them. So many people don't.

So many people don't? It's illegal, and I assume they go after you if you don't pay. Student loans cannot be discharged during bankruptcy.

given the economy I am hesitant about investments?401K or anything else. We lost a bucket load in the last three years. Had it been under the mattress. . . where I like it. . .We'd still have it. Good luck.

[Aceon6]

So many people don't? It's illegal, and I assume they go after you if you don't pay. Student loans cannot be discharged during bankruptcy.

According to this NY Times article, the default rate was high in 2008 and was over 10% for students of for-profit institutions like Phoenix. According to the article, "In the 2008-9 award year, students at for-profit schools represented 26 percent of borrowers — but 43 percent of defaulters."

Yes, they go after you, but 1) you can't get blood from a turnip, and 2) some people just don't care.

[Bostonfan]

I think a "bit of both" approach is best. When I had the same situation, I did the minumum contribution to my 401k that my employer would match (.50 on the dollar up to 6%). Then I put all the rest towards paying down my loans Took several years, but once I had them paid off, I increased my 401k significantly.

I've never heard of the 401k provision that you outlined. So I agree with others who said to check it out again. In my company, there is a 4 year vesting schedule, 25% per year. That simply means the Company match was fully vested (i.e. - mine) after I'd been there 4 years. It's been ingrained in me from my parents to take advantage of the "free" money that comes with a 401k employer match.

Once I was debt free, I did the maximum contribution into my 401k per year ($16,500). I was able to adjust my budget accordingly and make it all work. I'm looking at Roth IRAs now too, although I haven't started investing in any yet. I'd rather sacrifice a bit now financially to secure a better retirement situation later. Hopefully it will pay off.

Good luck!